The forex (FX) 1 market volatility experienced amid the COVID-19 crisis in 2020 has not entirely dissipated through the first four months of 2021. An improving economic backdrop, along with recent rises in US inflation expectations and interest rates, have somewhat altered global currency dynamics. Here are the latest views from members of our global fixed income platform.
At a high level
As of this writing, we continue to see the most attractive global currency opportunities in non-dollar crosses. 2 Supply bottlenecks worldwide and pent-up consumer demand will likely support developed market (DM) trade and commodity-linked DM currencies, while continued US economic outperformance and concurrent higher US yields could pressure select high-beta currencies in the emerging market (EM) space.
The US dollar
We see potential for gradual US-dollar (USD) depreciation in 2021, as medium- to longer-term conditions for the USD become broadly less supportive in the form of an eroding yield advantage, sizable twin deficits, 3 and the US Fed’s commitment to maintaining easy monetary policy in spite of improving fundamentals. The recent stabilization of US real yields and expected progress in European vaccinations may also contribute to USD weakening over the coming weeks.
However, we think foreign currency strength will be spotty going forward and are also mindful of the USD’s recent positive correlation to higher US Treasury yields, which may provide a short-term tailwind for the greenback. Additionally, the USD “smile” characteristic has been evident year to date, where the greenback strengthens in the case of both a better-than-expected US economic outcome (US economic outperformance accompanied by higher US yields) AND a worse-than-expected global economic outlook (falling US yields and a strong USD).
Other developed markets
We generally favor commodity-linked DM currencies relative to their perceived “safe-haven” counterparts, such as the Japanese yen and the Swiss franc:
- The Bank of Japan and the Swiss National Bank will likely tighten monetary policy only after other major central banks have done so, while a European growth rebound still depends on the evolution of the pandemic and measures to protect public health.
- Commodity exporters that have dealt well with the health crisis, such as Australia, Norway, New Zealand, and Canada, should see their currencies benefit further into 2021 as their economies normalize more quickly than less fortunate countries.
- We have a neutral outlook on the British pound. The Bank of England’s rhetoric has signaled less chance of further policy easing, while fiscal expansion has been greater than expected. Although the UK’s vaccination drive has outperformed Europe, the nation has yet to fully recover from the pandemic.
We have a mixed outlook on EM currencies at this time. Rising US yields, decreased global risk appetites, idiosyncratic political concerns, and the wide range of potential COVID outcomes and vaccine distribution paths could weigh on some EM currencies. Longer term, however, EM FX valuations continue to screen below estimates of fair value, as they were already under pressure when many investors implemented currency-hedging strategies in response to the impact of COVID.
China wants its currency policy to become more predictable and is making a concerted effort to “internationalize” the yuan. Meanwhile, there is a growing consensus that the decades-long trend toward globalization is slowing and that China will likely suffer the consequences.
However, Chinese exports to the US are on the rise, despite headwinds from the ongoing trade war and economic decoupling. Many countries will likely reap the mutual benefits of increased trade with China and won’t necessarily be put off by escalating US-China tensions. Indeed, China has already begun reaching out to its neighbors and others to trade more aggressively (Figure 1).
1Forex (FX) refers to the global electronic marketplace for trading international currencies and currency derivatives. | 2A “cross currency” refers to a currency pair or transaction that does not involve the US dollar. Common cross-currency pairs involve the euro and the Japanese yen. | 3Economies that have both a fiscal deficit and a current-account deficit are often said to have “twin deficits.”